The biggest financial challenge that retirees face is how to make their savings last the rest of their lives. Being smart about how you decide how much to withdraw from your retirement nest egg is essential to stretch your savings as far as it needs to go. Several strategies exist for people to follow in retirement, and they each have their pros and cons. By looking at all of these strategies in more detail, you can get a better sense of which is most likely to work for you and your financial situation.
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The simple solution: the 4% rule
The best-known retirement withdrawal strategy is known as the 4% rule. Using this strategy, you withdraw 4% of your total retirement nest egg in the first year of your retirement. Subsequently, you calculate future annual withdrawals by taking the previous year's amount and then adjusting it for inflation. So if you withdrew $10,000 last year and inflation ran at 2%, then in the current year, you would withdraw $10,200.
The primary benefit of the 4% rule is its simplicity. It's trivial to calculate the right withdrawal, and it's easy to plan for retirement using the 4% rule calculation as a guide.
There are shortcomings to the 4% rule as well. Some of the biggest include the following:
- There's no guarantee that future performance in the financial markets will be consistent with the past performance on which the 4% rule is based. Low bond rates and a long bull market could make using the rule in the future more dangerous than past research would suggest.
- The rule is particularly susceptible to large market declines early in retirement. These can strain your resources at a sensitive time for the longevity of your portfolio.
- Much of the time, the 4% rule is too conservative, having you withdraw less than you could prudently take. That can result in working longer than you otherwise would to save up a bigger retirement nest egg than you really need.
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Incorporate market movements into your withdrawal strategy
One way to deal with the shortcomings of the 4% rule is to allow for further adjustments to annual withdrawals based on market movements. If the stock market moves against you early in your retirement, then being able to cut your withdrawal by even a small amount can go a long way toward improving the longevity of your retirement savings. If the market does well, then you might be able to boost your withdrawals every year and still maintain the financial security you need.
One way to incorporate changing portfolio values is to use the IRS formula for required minimum distributions. Researchers at the Center for Retirement Research at Boston College looked at using the RMD rules, which have withdrawal percentages rise gradually over time but require recalculation of your total savings each year. The logistics of getting enough cash to distribute when withdrawal rates approach 10% at age 80 can be difficult, requiring principal drawdowns that many retirees are reluctant to make. Despite those concerns, using a value-adjusted alternative to the 4% rule can make more sense for some retirees.
Create guaranteed streams of income
One reason why withdrawal strategies are complicated is because they have to deal with uncertainty. However, retirees usually have access to at least some guaranteed income streams, and you can add others as the occasion warrants.
Social Security provides lifetime income that's adjusted for inflation each year, and so the larger you can make your Social Security payments, the better a job they'll do in protecting your finances. Waiting to claim retirement benefits is one way to boost your monthly benefits, but you can also look at working longer than you otherwise would to maximize your work history.
Purchasing immediate annuities also gives you guaranteed income. However, expecting to get enough at current rates to replace a 4% rule-style withdrawal strategy isn't realistic for many newly retired people. Annuity quotes take age and gender into account in most cases, and for some, the option to take annuity payments can lead to greater financial security.
Be smart about your retirement savings
It's important to make sure that your savings will last your entire retirement, and the right withdrawal strategy can help you get that job done. Knowing that all of these alternatives exist will put you in a better position to decide which one fits your financial personality and needs the best.
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